Of abbreviations, acronyms and financial crisis

December 05, 2008 15:08 IST

With all the knowledge, experience and wisdom, the financial markets from Wall Street to Dalal Street have gone through several cycles of boom and bust, which have influenced equally the profound and profane, leading them into acts of stupidity and naivete.

At the heart of these predictable manifestations of business cycles usually were financial instruments which became so popular that they came to be more commonly referred to by their abbreviations or acronyms than their original names.

A few examples of such instruments are LBOs, dot-com companies, BRs, KP-10 scrips, Badla, ALBM, PNs, CDSs and CDOs.

The pattern of a financial instrument known better by an abbreviation, becoming a source of financial disaster, seems to be repetitive. Generally when a person is referred to by a nick name or a short form of the original name, it indicates closeness of the person or his popularity or notoriety.

Likewise, when a financial instrument becomes known by its shorter form, it signifies its widespread use. A financial instrument becomes popular, when it is easy to use and also provides an opportunity to make a quick buck. For this, the instrument must have a leveraging potential and a sufficient hype must be built around it.

Investors then become like "lotus eaters", drawn to the instruments by the sweet scent of greed and oblivious to the underlying risk. When lot of people invest in such leveraged instruments, leverage increases and so does the risk and the march of folly begins.

Leveraged Buy Out, a financing mechanism for acquiring companies, prevalent since the mid-1950 became popular as LBOs on the Wall Street, during the leveraged buy out boom of 1978-89.

This was followed by an intense period of speculative excess and market misconduct, which ended with the indictment of the principal actors -- Michael Milken, Ivan Boesky and Denis Levine and the bankruptcy of Drexel Burnham Lambert, the firm which provided high risk, high yield debt financing for LBOs.

By the late 1990s, the internet companies became important investment opportunities and became more widely known as "Dot com" companies. The ballyhoo around dot-com companies created the tech-bubble and the accompanying investment mania, which burst in March 2000 with predictable consequences on the world stock markets.

Banker Receipts used in the late eighties in India for trading in government securities, became BRs when these were popularised by Harshad Mehta who used these in combination with Ready Forward Transactions to siphon off money from the banking system into the stock market and manipulate stocks.

The market misdemeanour came to light in 1992, ending the artificial bull run on the Indian stock market. There was a bull run again between 1998 and 2000, aided this time by the stock broker Ketan Parekh, who whipped an euphoria around the story of India as the emerging software giant.

He used this story to manipulate stocks of 10 new economy companies. These were so popular that Ketan Parekh became well known only as KP, and the group of 10 securities as K-10 stocks. What followed is common knowledge now.

The Participatory Notes -- off shore derivative instrument used by the FIIs since 1996, -- became PNs in the last few years to the delight of the market and agony of the regulators. The "contango and backwardation" mechanism prevalent once on the London Stock Exchange and the Paris bourses became "badla" on the Indian bourses -- a term borrowed from the Kolkata's "katni" market and was the cause of several episodes of market misbehaviour.

Credit Default Swaps and Collateralised Debt Obligations were obscure financial instruments for banks and bondholders, in the US in the 1990s. Between 1998 and 2001 these instruments were used to spread risk of $1trillion in loans without causing any trouble in the market.

But by 2006, due to their wide advocacy by Bear Stearns and other investment bankers, the outstanding amount rose quickly to $20 trillion. By then Credit Default Swaps and Collateralised Debt Obligations had become CDSs and CDOs. The market of structured finance had expanded drawing speculative investors, hedge funds, US and other foreign banks to the market.

Once the housing market collapsed in the US, these instruments shook the foundations of the world's financial system.

Is there a lesson or two in this repetitive pattern?

Yes. First, the regulators and regulations need to be watchful of market practices when any new financial product which has a leveraging potential, is introduced in the market. But a fine balance is required to make sure that innovation is not hamstrung by regulation.

Second, contrary to general belief, financial disasters are rarely black swan events. At least the present one was not. It is possible to hear them coming much before these can be seen. But there must be willingness to keep the ear to the ground to hear the hooves of impending disaster.